The hold-up problem is a bargaining power situation that arises from verbal or non-standardized contracts. As such, it usually has greater impact on small businesses, though it may occur between large companies.

Example

Setting

Suppose you are the sole salad maker in some small area and you have made an verbal agreement with a farmer to deliver fresh lettuce every morning for a specified price.

Seller's power

Without the lettuce, you cannot produce fresh salad that day and will lose significant revenue. The farmer may, at the time of delivery, "hold-up" your business and demand a higher price. Provided the new price is not prohibitively high (i.e. the costs of the lettuce are not higher than the costs incurred by shutting down for a day), you will be forced to buy the lettuce at a higher price.

Buyer's power

There is also the situation in which you are the largest customer of this particular farmer, and at the time of delivery, you demand a lower price for the lettuce. If the farmer cannot sell his lettuce elsewhere, then he is forced to accept a lower price.

Prevention

There are a few ways to prevent the hold-up problem from occurring, though the optimal solution depends on expected costs and benefits.

Vertical integration

If a contract is unwieldy, or it is more cost effective to simply produce the input (in this case, lettuce), then it may make more sense to pursue vertical integration. This can be more expensive in some situations, but often allows for quality control and product experimentation (i.e. developing new products).

Competition

In a relatively large market with several buyers and sellers, hold-up problems occur less frequently and with less impact.